What is Behavioral Economics

An Illustration: Guess the Number Game

• The Decision: Choose a number between 0 and 100• Goal: Win the game by choosing the number closest to 2/3 of the average of

the guesses.• Complete knowledge, Self-Interested Nash Equilibrium: All guess zero• Typical average: 19, so a winning guess might be 13 rather than zero.• Best choice depends upon your ability to judge how others will think

• One possibility: All pick at random, so average is 50. Then the best guess for you is 33.

• But, you should pick 22 if you think others will pick 33. As in chess, deeper thinking by others requires even deeper thinking by you for success.

An Illustration: Hyperbolic Discounting

• Which do you prefer?• $100 today, or $105 a week from now.• $100 a year from now, $105 a year and a week from

now

An Illustration: Frame

Question: Will you have the surgery?

Frame 1: Of 100 people having surgery, 90 live through the post-operative period, 68 are alive at the end of the first year and 34 are alive at the end of five years.

Frame 2: Of 100 people having surgery, 10 die during surgery or the post-operative period, 32 die by the end of the first year, and 66 die

by the end of five years.O

Behavioral Economics Definitions• Behavioral economics is the name we give to the research enterprise that seeks to

augment and amend the existing body of classical and neoclassical economic theory to achieve a more realistic picture of economic process. (Herbert Simon)

• The introduction of insights drawn from social psychology into (macro) economic behavior (George Katona )

• A research approach to economics which (1) rejects the notion that positivism is the sole methodological foundation for economic research, (2) refuses to accept the use of deductive reasoning as a sufficient basis for a (social) science, (3) dislikes static analysis of equilibrium as representing outcomes relative to disequilibrium processes, and (4) object to the simplistic economic model of rational agents exhibiting optimizing behavior (1984, p. 1).(Gilad, Kaish, and Loeb)

• Behavioral economics is a school of thought distinguished by the fact that it is much less narrow, rigid, intolerant, mechanical, separate, and individualistic than mainstream economics (Tomer).

Key Contributors to Behavioral Economics

• George Katona: Starting in late 1940, used surveys to support the idea that the level of consumption spending has a highly psychological component. Referred to by some as the Father of Behavioral Economics.

• Herbert Simon (Nobel Aureate) : In 1950s, replaced maximization assumption with satisficing assumption. Limited cognitive capacity typically precludes maximization, spawning the term bounded rationality. Under bounded rationality, behavior is determined by a pair of scissors, where one blade is the decision maker’s cognitive limitations and the other blade is the particular environment.

• James March and Richard Cyert: Developed a theory of how firms behave using bounded rationality as the underlying basis.

• Gerd Gigerenzer: Heuristics are developed that are tailored to particular decision making environments that effectively allow the decision maker to effectively cope with limited cognitive capacity.

• Reinhard Selten (Nobel Aureate) : Game theory applications of limited cognitive capacity.

• Harvey Leibenstein: Applications of bounded rationality to understanding the efficiency and inefficiency that may exist within a firm.

• Daniel Kahneman (Nobel Aureate) and Amos Tversky: People predictably violate rationality axioms when the outcome of a choice is uncertain and when the decision context changes in certain ways.

Key Contributors to Behavioral Economics

• Richard Thaler: Identified biases in behavior relative to that predicted by traditional economic theory. Many practical applications of behavioral economics.

• George Akerlof (Nobel Aureate) : Applications of bounded rationality to labor market, savings, education. A theory showing how identity can influence economic behavior, connecting economics and sociology.

• Vernon Smith (Nobel Aureate) : A pioneer of experimental economics, including much thought about behavioral issues.

• Richard Nelson and Sidney Winter: Applications of evolutionary theory to explain development of habits and routines.

Behavioral Observations

• Anchoring• Cognitive Dissonance• Endowment Effect• Mental Accounting• Confirmatory Bias• Hindsight Bias• Status Quo Bias• Law of Small Numbers Bias• Vivid Information Bias• Framing effects• Learning• Use of Rules of Thumb in Decision-Making

Behavioral Observations

• Overconfidence• Wishful Thinking• False Consensus Effect• Curse of Knowledge• Preference Reversals• Fairness• Herding• Procrastination

Behavioral Theories/Models

• Loss Aversion• Endowment Effect• Hyperbolic Discounting• Social Preferences• Satisficing• Reference dependent utility• Diminishing Sensitivity• Reciprocity • Gift Exchange• Efficiency Wage• Internality• Sophisticated versus Naïve Discounters

Criteria for Evaluating Theories

• Prediction Accuracy (Stigler)• Generality (Stigler)• Tractability (Stigler)• Parsimony (Rabin)• Realism (Simon)• Positivism (Hume)• Falsifiability (Popper)• Existence of a Reasonable Competing

Theory (Lakatos)

Sample Applications• Loss Aversion

o Consumers are more averse to lowering consumption in response to bad news about income than they are to increasing consumption in response to good news

• Fairnesso Subjects contribute to public goods more than can be explained by

pure self-interesto Wage decreases are viewed with a special disdain, implying wages

are sticky in the downward direction, keeping unemployment from being eliminated

• Reciprocityo If others conserve water, you are more likely to conserveo An employee who feels mistreated is more likely to sabotage the firm.

Sample Applications• Law of Small Numbers Bias

o We underestimate how often a good financial analyst will be wrong a few times in a row. and how often a clueless analyst will be right a few times in a row.

o People tend to generate spurious explanations for long streaks that are determined by chance

o The gambler’s fallacy

• Anchoringo Overestimate happiness gain from winning lottery

• Hindsight Biaso Hearing the report of a mass shooting increases the

perceived probability of such an occuranceo “I knew it all along,” (but your really did not)

Sample Applications• Hyperbolic Discounting

o Pay a Gym Trainer o Christmas savings clubso In general, act to restrict your options

• Confirmatory Biaso We ignore information that does not support our initial

hypothesiso Ambiguous information further affirms our initial

hypothesis• Status Quo Bias

o Libertarian Paternalism (Nudge) Savings plan opt-out rather than savings plan opt-in Put fruit in front of higher calorie desserts

Criticisms of Behavioral Economics

• Too many behavioral theories with too few applications

• The many assumptions underlying behavioral models need to be reduced to a smaller number of more primitive assumptions

• Not clear how to identify equilibrium versus non-equilibrium behavior

How Economics May Become More Behavioral

• Model decision-making using learning processes, whereby a decision maker becomes more sophisticated as learning occurs.

• Environment dependent sophistication (or decision ability)• Less representative agent models, more heterogeneity• More use of our understanding of human cognition in modeling

decision making. • More focus on developing theories that explain observations

(descriptive theories) and less focus on developing theories that are axiomatically consistent (What Thaler calls normative theories)

• More focus on how emotions influence choice

ReferencesFundenberg, Drew (September 2006) Advancing Beyond Advances in Behavioral Economics Journal of Economic Literature 44, 694–711.

Hosseini, Hamid (2003). The Arrival of Behavioral Economics: From Michigan, or the Carnegie School in the 1950s and the Early 1960s? Journal of Socio-Economics 32 (2003) 391–409.

Rabin, Mathew (March, 1998). “Psychology and Economics,” Journal of Economic Literature, 36: 11-46

Thaler, Richard (Winter, 2000). From Homo Economicus to Homo Sapiens.” Journal of Economic Perspectives 14(1), 133-141.

Thaler, Richard H. and Cass Sunstein (2003). “Behavioral Economics, Public Policy, and Paternalism: Libertarian Paternalism,” American Economic Review, Papers and Proceedings 93: 175-179.

John Tomer, “What Is Behavioral Economics?,” Journal of Socio-Economics, 36(3), June 2007, 463-479.